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Posted by Brett Gustafson on Jun 13th, 2024

Portfolios With a Purpose – Not Dead, Just Evolving

This week, Market Ethos tackled the concept of Crisis Alpha. The analysis details that higher correlation amongst asset classes has many portfolio construction practitioners looking elsewhere in the investment universe for the crucial element of diversification. Throughout the past couple of years, there has been a surge in headlines that the classic 60/40 portfolio is dead. This surge makes total sense. The first major rate hiking cycle since the 2008 financial crisis has raised concerns surrounding diversification simply because the correlation between the two major asset classes increased, and portfolios were hurt in the process. In our view, the 60/40 portfolio is not dead; this is simply a cycle we have seen before, but with any challenging period comes the opportunity to evolve.

Alternatives, whether liquid or illiquid, play a role in most portfolios, but the portfolio manager must have a clear purpose for including them. They demand more consideration than traditional investments, and their intended purpose/return stream should be something that cannot be achieved through traditional investments. We have analyzed countless portfolios throughout our careers, and we can say for certain that most high-net-worth models include some form of an alternative investment. Some portfolios simply have a 5% sleeve, while others can creep up towards a heavy overweight of 40%. For most individual investors, the 60/40 will be able to get the job done, but as you move up the spectrum of net worth and portfolio size, complexity tends to increase. If there is an opportunity to move the efficient frontier up and to the left (reduce risk and increase return), it is certainly worth exploring.

If the 60/40 portfolio is going to evolve successfully, it will not be easy. Additional work will be required to manage and maintain portfolios properly. This will require more time, much of which many portfolio managers do not have. When integrating alternative investments into a portfolio, it is crucial to be aware of potential challenges to ensure the best outcomes for clients. Whether you are attempting to integrate alternatives into a portfolio or are currently managing an alternatives sleeve, we have observed a few missteps or biases along the way that are worth sharing.


It is often observed that portfolios incorporating alternative investments are typically very clustered. Despite the massive landscape of alternative strategies available, managers tend to develop a comfort zone with one particular strategy and, without noticing, over-concentrate in that area. This results in an alternative sleeve that is skewed towards similar or marginally different alternative investments.

Perhaps a portfolio manager (Manager B) becomes proficient in the area of real assets and subsequently chooses 2 or 3 real asset instruments to round out their alternative sleeve. Being well-versed in real assets might bring the perception that it is a safer bet due to their expertise and success. Another manager could potentially focus entirely on private equity (Manager A) – either of these options results in neglecting the broader spectrum of alternatives such as hedge funds, commodities, infrastructure, or real assets. Neglecting is fine if there is an economic reason for doing so; it's when they are ignored altogether that concerns around concentration arise. We do not want to ignore other opportunities that could bring different risk-return profiles and enhance portfolio diversification.

This phenomenon is a manifestation of familiarity bias – just as it says in the name, this is a cognitive bias where investors prefer to deal with what they are familiar with. It brings with it a sense of comfort and allows them to overlook potentially beneficial alternatives to the solution they are currently using. Addressing this bias requires consistent effort to analyze the full spectrum available in a disciplined approach to broaden the overall scope.

Managing familiarity bias

A solution to concentration is simply being aware of it, which in turn can also assist with managing familiarity bias. Looking at the 3 managers in the table, it is fairly obvious which manager is diversified across the alternative landscape. This is the lens that we use within our portfolio process to ensure we have the proper diversification within that sleeve of the portfolio. We have found that these four categories have the ability to capture much of the product offerings available to portfolio managers. It is rather simple, but it does not need to be complex.

Risk Management

Most portfolio managers are fairly strong in managing traditional market risk. This is simply the risk of losing money due to overall market movements. We know that over time, a properly diversified portfolio will have its ups and downs. Alternative investments are introduced to mitigate some of this market risk through diversification and exposure to uncorrelated return streams. It is true that some alternatives can manage market risk; however, thought must be given to the less visible risks that will now be introduced to the portfolio through the use of non-traditional investments.

Long/short equity strategies have the ability to take long positions in stocks that are expected to rise and shorten the ones they feel will struggle. This strategy will, of course, reduce market risk, but it now amplifies security selection risk. Choosing the wrong stocks to go long or short can result in major underperformance. Going back to having a clear purpose for the alternative in a portfolio, if the market goes on a tear, an LS equity strategy will likely lag; this should be known well in advance so that in this scenario, the manager does not divest from the strategy.

Leverage is another risk. While it can increase gains, it can also magnify losses, especially in volatile markets. It is important to understand the extent of leverage used and the scenarios when this may change. Investors will also have liquidity risk, which means it is prudent to only allocate long-term dollars to these investments. The focus should be on how it interacts with other components of the portfolio and how the inclusion of alts aligns with the investors' risk tolerance and goals.

Make no mistake; most alternative investments are a form of 'captive capital.' Yes, there are now liquid alternatives in the marketplace. However, for the illiquid options, you are giving up control over these managers, which is the ultimate form of trust. Alternative managers have the ability to reduce withdrawal opportunities, gate the portfolio, or eliminate distributions. The risk of any of these happening is non-zero; therefore, the decision to allocate capital must be well thought out, and the investment should provide something that is not available in the traditional landscape. But for some investors, a loss of control for outperformance is acceptable for their risk tolerance. As long as portfolio managers can avoid blind trust akin to a form of Stockholm syndrome, they can maintain objectivity and ensure that these investments genuinely add value to the portfolio.

These additional risks do not suggest avoiding alternative investments; they simply suggest that the process necessitates a higher level of due diligence and ongoing attention. Managers should understand fully how the product works and the purpose of it in the portfolio. Within that due diligence process, there will be challenges, but focus on the historical performance, management team, underlying assets' liquidity, and, of course, the risk characteristics.

Performance Chasing

The typical performance-chasing focus for traditional investments is usually on either maximizing gains or minimizing losses. However, with many alternative investments, the focus of performance chasing is often on achieving resilient or uncorrelated returns with the rest of the portfolio. But let's be honest: investors only truly want a negative correlation when the market is falling. If the market is soaring and that negative correlation persists, there's a high chance they would divest from the investment.

This would be known as recency bias, where investors place too much emphasis on recent events or trends when making investment decisions. When the market is performing well, investors may abandon negatively correlated investments because they are focused on the recent upward trend. They fail to appreciate the long-term benefits of diversification and downside protection that those negatively correlated assets provide.

When the market runs into trouble, any alternative strategy that holds up well often sees significant inflows afterward. For example, in 2022, Commodity Trading Advisors (CTAs) became highly sought after. CTAs typically use momentum strategies and target a diverse range of assets, including stocks, bonds, and commodities, taking both long and short positions. Despite a history of avoidance by many investors due to previous bad experiences, the strong performance of CTAs in 2022 led to a surge of investments in these strategies.

Alternatives still provide investors with resilient returns, but it has certainly changed over time. Up until 2005, you could roughly expect a 40% spread between upside and downside capture. Since 2006, that spread has minimized materially to 10%, with the alts capturing a little over double the downside. The diversification benefit across the spectrum of alternatives is simply not what it once was. That does not mean there are no alternatives out there that can provide that benefit. There simply needs to be more due diligence surrounding the product you are evaluating for the portfolio.

Alternatives still offer diversification, but not really as much as they used to

A lot of alternatives will indeed have historically uncorrelated returns, but just remember that they are likely to lag to the upside if you chase that resiliency in bad times. The challenge is to avoid divesting due to upside capture frustration. Remember why they were included in the portfolio in the first place, as uncorrelated return streams can have benefits in both positive and negative market conditions.

Final Thoughts

While alternative investments offer potential benefits in terms of diversification and resilient returns, they also introduce complexities and risks that demand careful management. Incorporating these investments into a portfolio requires a deep understanding of the strategies, rigorous due diligence, and an integrated approach to portfolio construction. While the traditional 60/40 portfolio remains relevant, the evolving investment landscape highlights the importance of embracing alternatives while being mindful of challenges like concentration and performance chasing. By maintaining clarity on the purpose of these investments and having a strong process, investors can maximize the advantages of alternatives while mitigating their unique risks in both favourable and adverse market conditions.

— Brett Gustafson is a Portfolio Analyst at Purpose Investments

Insights with Purpose

At Purpose, we are attempting to change the status quo within the investment industry. Mainly, the enigmatic standards by which the industry operates. We are an open book when it comes to portfolio design and discussions surrounding our outlook and strategies. We want to make managing portfolios simpler for advisors and act as a sounding board for ideas. We start by running portfolio comparisons between your portfolios and ours. Not to say ours is right and what you are doing is wrong, but to understand the differences and have discussions surrounding the rationales. We aim to keep this discussion going quarterly; this is not a one-and-done service. We want to build our relationships with advisors so that the end client has a satisfactory investment experience.

If you want to know what exposures your portfolio is tilted toward, feel free to reach out to our team.  As the great Peter Lynch once said, “Know what you own and why you own it." 

Sources: Charts are sourced to Bloomberg L.P.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold, or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees, and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements ("FLS") are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as "may," "will," "should," "could," "expect," "anticipate," intend," "plan," "believe," "estimate" or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Brett Gustafson

Brett is a Portfolio Analyst at Purpose. He is responsible for relationship management and advisor support and focuses heavily on portfolio analytics for advisors, our own proprietary models, as well as equity research. With over nine years of experience in the investment industry, Brett started his career out as an Investment Advisor at a Canadian independent asset management firm where he cared for several high-net-worth families. Brett graduated from the University of Calgary with a Bachelor of Commerce degree. He is currently pursuing his CFA designation with the goal of becoming a Portfolio Manager.